When we met with the Committee just prior to Christmas, I suggested that, taking
an international view, 2013 could be described as a year that turned out not
to be quite as good as hoped for, but not as bad as feared. Nothing that has
occurred in the period since then would change that assessment.

One prominent international event was that, within hours of that hearing, the US
Federal Reserve commenced the ‘tapering’ of its monthly asset purchases.
This was a possibility we talked about at the time and, although the timing
of it wasn't known, it was considered likely that it would begin before
long. A further reduction in asset purchases was decided at the Fed's January
meeting.

After all the anticipation of this change, the actual announcement of the Fed's
decision caused little disruption in markets in December. During January there
was more volatility in markets, and a few emerging economies came under pressure,
with bond yields spiking and exchange rates declining.

It is important to keep this in perspective. Periods surrounding changes of course
by the Fed have often been times when market participants re-assess their positions
and their appetite for risk, and this occasion has been no exception. It isn't
necessarily the Fed action per se that is most important, but rather what it conveys
about the overall economic and financial environment. At such times investors
sometimes start to focus on risks to which they had hitherto been attaching
little significance.

Investors have not, however, fled from risk indiscriminately on this occasion, at
least to date. They have drawn distinctions between alternative classes of
investment and different countries. Long-term sovereign yields of the core
advanced countries have increased a little, but they remain low. With compressed
risk spreads, this means that borrowing costs for many private-sector borrowers
remain very low. The spreads over German yields for European sovereigns have
continued to fall. This suggests that actions by European policymakers have
had more influence on European markets than actions by the US authorities.
This is as one would expect, but it hasn't always been the case in the
past.

Moreover, not all emerging markets are experiencing the same pressure. Some that
experienced considerable turbulence in the middle of last year, when tapering
was first mooted, have seen less of that recently. This owes something at least
to policy responses in those countries in the intervening period. Among those
countries that have been under most pressure of late, genuine domestic sources
of risk can be observed in most instances. In several cases the market pressure
has resulted in policy responses, which were perhaps needed anyway.

In general then, tapering is proceeding, so far, about as well as can be expected.

In the meantime, forecasts for the global economy haven't changed much in recent
months. If anything they have inched higher. They suggest that 2014 growth
will be higher than in 2013, and at about average pace. More of the growth
is coming from the advanced countries, and proportionately not quite so much
from the emerging ones. That, too, is probably a welcome re-balancing in some
respects after the weakness of the advanced countries in recent years. Australia's
terms of trade have been little changed over the past year, though we still
assume they will decline further in the future.

Turning to the Australian economy, for some time our view has been that growth has
been running below its trend pace. The national accounts released a couple
of days ago don't significantly change that assessment. For the year to
the December quarter of 2013, real GDP rose by about 2¾ per cent. This
is roughly in line with the forecasts we have had for a while. The drivers
of growth are shifting. As we have been saying for some time now, and as confirmed
in the recent survey of capital expenditure intentions by firms, the very high
level of investment spending by mining companies has turned down, and the decline
will accelerate over the coming year. Other areas of demand will provide at
least some offset. Export volumes for resources are growing strongly, as the
capacity that has been put in place by the high levels of investment comes
on line. For example, iron ore shipments have risen by about 85 per cent from
their levels of five years ago, to around 1.5 million tonnes per day. They
will rise further over the coming year or two.

It is clear that dwelling investment activity will rise strongly over the period
ahead. Over the past three months, approvals to build private dwellings numbered
almost 50,000. That is an increase of about 27 per cent from the figures of
a year earlier, and is the highest three-month total in the 30-year history
of this series.

Consumer demand has had a firmer tone over the summer, after a fairly lengthy period
of more subdued outcomes. This is evidence in the retail trade and national
accounts data and is confirmed in information from the Bank's liaison.
Consumer sentiment does still seem a little skittish, though, and while we
expect consumption spending to grow in line with income or perhaps a little
faster, consumers are unlikely to be the drivers of growth that they were prior
to the financial crisis.

Business investment spending outside mining, which has been very low indeed, is bound
to pick up at some stage. The signs of improved conditions and confidence that
we have observed in some sectors will help, and the early indications of an
improvement in capital spending expectations are apparent. Those are, however,
quite tentative at this point and firms are looking for recent signs of improved
conditions to persist before committing to expanded investment spending. Public
final spending is scheduled, according to the announced plans of federal and
state governments, to be quite weak.

The expected ongoing effects of very low interest rates and a somewhat lower exchange
rate have resulted in a slight lift in forecast growth for the second half
of this year and in 2015. This was reflected in our most recent published forecasts
released last month. We haven't made any further changes since then.

With growth having been below trend, job vacancies declined, employment growth weakened
and unemployment rose in 2013. Some forward indicators have stabilised and
then improved a little of late, which is promising. But even with this, and
with a slightly better growth outlook, the labour market will probably remain
soft for a while yet, given that it lags changes in activity. This has seen
the pace of growth of wages decline noticeably.

Turning to consumer price inflation, the recent data show inflation in underlying
terms at about 2½ per cent over the course of 2013, and a pace higher
than that in the second half of the year. This is a change from the middle
of last year, when we were receiving data that were lower than expected.

Part of the increase in inflation is explained by the effect of the depreciation
of the exchange rate, which has resulted in increases in prices of traded goods
and services. But that does not account for all the result and it is, at least
on the surface, something of a puzzle that underlying inflation moved up while
growth in labour costs moved down. There may be a re-building of margins in
some areas, particularly those where demand conditions have improved a little
from the very weak situation earlier. There may also be an element of noise
in the quarterly data.

The view we have taken, pending further evidence, is that there is probably both
noise and signal in the result. Hence, our assessment is that inflation is
not quite as low as it might have looked six to twelve months ago, but nor
is it accelerating to the extent a literal reading of the latest data might
suggest. The general situation – 18 months of below-trend growth, a rise in unemployment,
a marked slowdown in wages – is not one that would be obviously associated
with a sustained rise in price pressures. Our view remains that the outlook
for inflation, while a little higher than before, is still consistent with
the medium-term target.

Monetary policy is very accommodative. The cash rate has been unchanged since August
last year. It and most borrowing rates are at multi-decade lows. The sorts
of things that are normally expected to result from low interest rates are
increasingly in evidence:

savers are looking for higher return assets as the yield on safe assets has fallen

asset prices have risen

credit growth has picked up somewhat for households, and particularly for investors
in housing, where it is running at an annualised pace of close to 9 per cent

construction of dwellings is set to rise, probably quite strongly

liaison suggests that lenders are becoming more accommodating to potential business
borrowers and few complain about availability of credit

the exchange rate has depreciated, though it is still high by historical standards.

On the whole, then, accommodative monetary policy is playing its part in supporting
sustainable growth in demand, consistent with the inflation target.

Of course, the outlook contains many uncertainties, not least the ‘hand over’
from mining investment spending to sources of demand outside mining. In some
important respects, the basis for such a handover is coming into place, as
I have just described. The question then is: will the additional demand likely
to be generated outside mining as a result of these trends be just the right
amount to offset the large decline in mining investment spending, so keeping
the economy near full employment?

No-one can answer that question with great confidence. Moreover, even if it were
possible for forecasts to be much more accurate than experience could possibly
lead us to hope, it could not be assumed that a shortfall in demand could necessarily
be made good in short order by monetary policy. Monetary policy can have a
powerful effect on the general environment, but it cannot hope to fine-tune
the quarterly or even annual path of aggregate demand.

At the present time we judge monetary policy to be doing the things it can reasonably
be expected to do in the circumstances we face. We have signalled the likelihood,
if the economy evolves more or less as expected, of a period of stability in
the cash rate. As well as the low level of interest rates generally, a sense
of stability should be of some help for businesses and households as they form
their plans.